The authorities' program is designed to help stabilize the domestic financial system against a backdrop of global deleveraging and a domestic crisis of confidence, and to facilitate adjustment of the economy to a large terms-of-trade shock. The authorities' plan incorporates monetary and exchange rate policy shifts, banking recapitalization, and fiscal and incomes policy adjustments.

"The Ukrainian economy, especially the banking system, is experiencing considerable stress. Falling prices for Ukraine's major export, steel, have led to a substantial deterioration in Ukraine's current account outlook. This terms-of-trade shock, along with existing vulnerabilities—high inflation, relatively low foreign exchange reserves compared with short-term external debt, significant exposure of banks to foreign funding, balance sheet mismatches, and a weak underlying fiscal position—interacted with the drying up of liquidity caused by the international financial crisis and led to a significant slowdown in capital inflows.

"The authorities' program, supported by the two-year Stand-By Arrangement with the IMF, aims to restore financial and macroeconomic stability by adopting a flexible exchange rate regime with targeted intervention, a pre-emptive recapitalization of banks, and a prudent fiscal policy coupled with tighter monetary policy. Resolute implementation of the program should help reduce inflation to single digits by the end of the program.

"The flexible exchange rate regime, backed by an appropriate monetary policy and foreign exchange intervention, will help absorb external shocks and avoid disorderly exchange market developments. The recent unification of official and market exchange rates should increase clarity about the regime. Recently imposed exchange controls will be phased out as confidence rebuilds. Plans to accelerate progress towards inflation targeting and enhance the independence of the National Bank of Ukraine are important to provide the nominal anchor under the flexible exchange rate regime over the medium term. In the near term, as liquidity pressures diminish, tighter monetary policy will be necessary to guard against inflation.

"A pre-emptive bank recapitalization will alleviate a potential credit crunch that could prolong and deepen the downturn in economic activity. Decisive measures that have been taken to allocate public funds to recapitalize banks and to facilitate bank resolution processes will ensure that problems can be dealt with promptly. Increased oversight, more targeted on- and off-site inspections, and improved cross-border supervisory cooperation will help to strengthen the financial system. A proactive strategy to resolve corporate and household debt problems will also be essential to reduce banking sector vulnerabilities.

"A prudent fiscal stance is planned, consistent with both the financing constraint and the need for recession-related social spending. The target of a balanced budget in 2009 will be kept under review in light of the macroeconomic, financing, and revenue outlooks. The targets would be achieved in part by expenditure restraint, and by a phased increase in energy tariffs. Ukraine's extensive safety net provides a backstop to protect vulnerable groups, and the program also allows higher funding for unemployment insurance and targeted income support.

"The authorities have developed a strong and comprehensive package of measures to address the challenges Ukraine is facing and the Fund has provided commensurate financial assistance. Decisive measures have already been implemented by the authorities, including the passage of anti-crisis legislation. Moreover, the authorities' policy framework is sufficiently robust to adapt to evolving circumstances. The commitment of leaders of the main political parties to the core elements of the program increases the prospects for successful program implementation. All these elements give confidence that the program will succeed in stabilizing economic and financial conditions," Mr. Portugal said.

ANNEX

Recent Economic Developments

Ukraine's economy has grown very rapidly since 2000, expanding by more than 7 percent on average. Initially, this reflected the utilization of large excess capacity and increased productivity supported by a series of structural reforms. Since 2005, growth has been propelled by real domestic demand, namely a credit boom driven by strong capital inflows as well as incomes policies that redistributed large terms-of-trade gains to the population.

By mid-2008, the economy was overheating. Credit growth exceeded 70 percent, CPI inflation exceeded 30 percent, wage growth settled in the 30-40 percent range, a buoyant property market pushed valuations to high levels, and imports surged at an annual rate of 50-60 percent. The current account deficit reached 7 percent of GDP in the second quarter of 2008.

The Ukrainian economy also became vulnerable along other dimensions, including high short-term external debt relative to reserves, high exposure of banks to foreign funding, balance sheet mismatches, and a weak underlying fiscal position. Problems came to the fore as commodity prices plunged and the global financial turmoil deepened. These developments have had a considerable impact on the real sector as reflected in the sharp 5-percent contraction of the manufacturing sector in September.

At the same time, a sharp slowdown of external capital flows raised concerns about the ability of banks and corporates to roll over existing credit lines. When the sixth largest bank, Prominvest Bank, was put under receivership, a widespread deposit outflow began with at least US$3 billion—4 percent of deposits—withdrawn during the first three weeks of October. Confidence in the country's banking system and currency weakened. Intervention by the National Bank of Ukraine (NBU) mounted in October, reducing reserves from US$38 billion to US$32 billion. In addition to providing liquidity, the authorities also imposed a set of exchange controls to stem outflows.

The combination of weaker demand from Ukraine's trading partners, falling export prices, rising import prices, and reduced access to international financial markets are expected to weaken growth prospects. Taking these developments into account, Ukraine's overall financing needs for the next two years are large.

Program Summary

The authorities' program aims at restoring confidence in Ukraine's macroeconomic and financial stability by addressing the financial sector problems, facilitating adjustment to potentially large external shocks, and reducing inflation. The program is designed to respond flexibly to economic developments.

The program is based on projections that assume a global recession and continued deleveraging in international credit markets in 2009, implying a recession in Ukraine with deteriorating exports, limited external financing and a credit crunch. The projected impact on output—a 3 percent decline—is consistent with Ukraine's experience under similar circumstances in 2004-05. Under the program, inflation is expected to decrease to 17 percent by end-2009 from the projected 25.5 percent this year. The current account would compress to a deficit level of about 2 percent of GDP from the mid-2008 level of 7 percent.

Assuming a global recovery in the second half of 2009, the Ukrainian economy could be back at its estimated potential growth rate of 5-6 percent by 2011 with inflation at 5-7 percent by late 2011.Current account deficits are projected to remain small in 2010, in light of the weak economy, and to be moderate thereafter, allowing reserves to rise.

The key measures to achieve the objectives of the program focus on the following areas:

Monetary and Exchange Rate Policy

The program supports the implementation of a flexible exchange rate regime to help Ukraine better absorb the external shocks it now faces. Base money will be the near-term anchor for monetary policy until an inflation targeting regime can be implemented. The independence of the NBU will be strengthened, and in the near term, monetary policy will be tightened to help achieve the 2009 inflation objective of 17 percent. The program envisages eliminating exchange rate controls as soon as possible, and measures to improve the operation of the foreign exchange market, including cancellation of the foreign exchange transactions tax and a more transparent intervention policy.

Financial Sector Policy

The authorities intend to prepare a comprehensive bank resolution strategy that will include the resolution of problem banks and the recapitalization of viable banks to cushion the real economy from a potential credit crunch. The authorities have already resolved the sixth largest bank, Prominvest Bank, through a sale to a strategic investor.

The program further proposes to ensure that viable banks have access to liquidity; increase deposit insurance coverage to Hrv150,000 (about €20,000) from the current Hrv50,000, which will cover 99 percent of individual accounts; and strengthen the monitoring of banks, including through enhanced cross-border supervisory cooperation.

Fiscal Policy
The authorities will adopt a prudent fiscal stance while accounting for the need for recession-related social expenditures, including higher funding for unemployment insurance and targeted income support. Under the program, the deficit would not exceed 1 percent of GDP in 2008, and in 2009, the general government budget would be balanced (excluding bank recapitalization costs). Even with the substantial increase of 0.8 percent of GDP social spending during the recession, these fiscal targets are deemed attainable. However, given the uncertainties on economic prospects and the availability of financing, the authorities are prepared to adjust the targets as needed. To achieve their fiscal targets, the authorities are determined to correct the pricing policies in the energy sector and pursue a more balanced incomes policy by adjusting the minimum wage, pension, and social transfer increases in line with the projected inflation in 2009. These measures will help guard against higher inflation and depreciation. Ukraine has an adequate social safety net in place to protect the vulnerable against adjustment policies, which the authorities are prepared to expand should the need arise.

Ukraine joined the IMF as a member on September 3, 1992. Its quota is SDR 1,372 million (about US$2,049 million).

Sources: Ukrainian authorities; and staff estimates and projections.1/Policies assumed include: (i) increased exchange rate flexibility as from 2008; (ii) convergence of natural gas import prices to Western European levels (adjusted for transit) by 2010; (iii) pass-through of rising energy import prices in 2009; (iv) public-financed recapitalization of banks for a total amount of Hrv 54 bln (10 bln by end-2008 and 44 bln in the first half of 2009).2/The increase in the external debt ratio in 2009 reflects, inter alia, the inclusion of IMF money in public external debt.